Despite constant attempts by analysts and the media to complicate the basics of investing, there are really only three ways a stock can create value for its shareholders:
- Dividends.
- Earnings growth.
- Changes in valuation multiples.
In this series, we drill down on one company's returns to see how each of those three has played a role over the past decade. Step on up, Berkshire Hathaway
Berkshire shares returned 62% over the past decade. How'd they get there?
Warren Buffett's company famously doesn't pay a dividend, so we can scratch that off the list.
Earnings growth over the period was sensational. Berkshire's normalized earnings per share grew at an average rate of 20.6% over the past 10 years. The company's earnings can be notoriously volatile because of derivative contracts Buffett took out on various global stock indexes, but even averaging together a few years of earnings shows Berkshire's earnings have grown immensely over the past decade, especially considering the state of the global economy. Recent investments in companies like Bank of America
But if earnings growth was so strong, why were Berkshire's returns so meager? This chart explains it:
Source: S&P Capital IQ.
Berkshire's price-to-book value has dropped by nearly 50% over the past decade. What's incredible is that Berkshire was, by most accounts, reasonably valued 10 years ago -- the company used to trade at a price-to-book value well over two, which seemed reasonable given Buffett's ability to compound Berkshire's earnings at such a high rate.
The decline in Berkshire's price-to-book value over the past year has been striking. Indeed, valuations fell far enough that Buffett began using Berkshire's cash to repurchase shares in September for the first time ever. "[T]he underlying businesses of Berkshire are worth considerably more than" the current price, the company said in a statement.
Even factoring in Buffett's mortality, I don't know many who think current valuations are reasonable. Over the past 10 years, Berkshire's earnings growth was suppressed by compression valuations. Over the coming one, they may enjoy the tailwind of expanding valuations.
Why is this stuff worth paying attention to? It's important to know not only how much a stock has returned, but where those returns came from. Sometimes earnings grow, but the market isn't willing to pay as much for those earnings. Sometimes earnings fall, but the market bids shares higher anyway. Sometimes both earnings and earnings multiples stay flat, but a company generates returns through dividends. Sometimes everything works together, and returns surge. Sometimes nothing works and they crash. All tell a different story about the state of a company. Not knowing why something happened can be just as dangerous as not knowing that something happened at all.
Add Berkshire Hathaway to My Watchlist.
